ETF Investors Bet On ‘Taper Lite’

U.S. Treasury bonds via iShares 7-10 Year Treasury (IEF) have gotten off the mat and moved higher over the course of 5 days. The SPDR Gold Trust (GLD) has resumed its downtrend by falling below a 50-day trendline. WisdomTree Dreyfus Emerging Currency (CEW) has rallied strongly in September. Meanwhile, most of the beneficiaries of a Federal Reserve commitment to the suppression of lending rates — homebuilders, timber producers, real estate investment trusts — head the leader-board over the last week.

In essence, virtually every asset class is performing in a manner that is consistent with the Fed doing little more than “saving face.” Specifically, investors believe that committee members will need to follow through on some reduction of bond-buying activity, but the reduction will be minimal and the statement will acknowledge increasing weaknesses in the domestic economy.

Frankly, I think investors have mostly interpreted the likelihood of Fed action (or inaction) correctly. Supposedly, the Fed is responsible for two things — steady employment and modest inflation. The worst labor force participate rate since 1978 is indicative of employment woes, not vibrant job growth, while exceptionally flat wages stoke the debate over whether inflation or deflation is the primary concern; either way, inflation is below Fed targeted levels. Topping it all off, budget stand-offs in Washington mean there is zero chance of fiscal stimulus, leaving the monetary authorities to do any of the heavy lifting.

Don’t misunderstand. If it were up to me, I would have ended the emergency quantitative easing back at QE1 and allowed the economy to heal on its own from there. So I am not advocating endless bond purchases with electronic money printing. Nevertheless, it is clear to me that the Fed has little reason to slow its purchases substantially, other than to break our collective addiction to unnaturally low lending rates. And the Fed simply does not have the stomach or wherewithal to break that addiction with a major tapering.

Indeed, one should expect an exceptionally modest tapering… a token gesture, if you will. My “guestimate” is 10% or $8.5 billion less, leaving the institution still in the market for the acquisition of a whopping $76.5 billion in U.S. debt each month. Moreover, I expect the Fed to acknowledge increasing weakness in the job market, which may be interpreted by investors as a sign that the Fed will not continue tapering activity until 2014 at the earliest.

Clearly, the 7-day stock market rally for the S&P 500 is largely tethered to a belief that the Fed won’t be very active on September 18. That said, there is a wide range of possibilities that might prove the bets of market participants as well as my “guestimate” wrong. Add the potential for the federal government to create yet another debt ceiling debacle, and I am content to keep plenty of cash on hand. It may be difficult to be patient for sell-offs, but patience is required for long-term investing success.

Taper Lite: Markets Believe That The Fed Will Barely Rein In Its Bond Buying